Thursday, September 04, 2008

Fitch Warns on Option ARMs...

I meant to cover this earlier in the week. Fitch (a major debt rating agency) has taken a look at the option adjustable rate mortgages (ARMS) and it's a fairly scary picture.

Negative Amortization mortgages gained in popularity from 2004 to 2007 as a way to give fringe borrowers a chance at finally owning a home. In essence, with a Neg-Am mortgage you pay a monthly payment that is less than the sum of your principal and interest with the balance that you owe added each month to the principal.

So, assume you bought $500k house with zero down. In a traditional 30yr fixed rate mortgage your monthly payment might have been about $3,000. However, with a neg-am mortgage and a 40 yr payback period your payment could be as low as $2,000. Your monthly payment falls b/c you're paying the loan back over 40 years!!! instead of 30, and the difference between your payment ($2,000) and you're actual obligation ($2,600) was simply added to your principal balance each month. So at the end of year 1, you would have paid $12,000 toward your house, but in fact you would now owe $507,200 (at the end of yr 2 $515k, yr 3 $523k, etc). This is essentially credit card financing for your house.

However, most of these mortgages put a 110% principal cap in their fine print (in our example the mortgage can't exceed $550,000). When coupled with the fact that most people chose to pay the bear minimum on their mortgage it has led to a rapid escalation of "recasts". Recasts are provisions built into the loan to charge a higher rate and require principal reductions.

"Though recent declines in the 12-month Treasury average rates have mitigated some risks, the majority of option ARM borrowers have elected to make the monthly minimum payment over the past 24 months,” Fitch said in the report. “As a result, a large number of these loans, especially those with 40-year amortization and 110% principal caps are expected to reach their recasts before the end of the five-year mark.”

The result? Fitch said it expects 90-day plus delinquencies — already ranging from 10 percent to 24 percent, depending on vintage — to more than double after recast for 2004-2007 vintage loans. It gets worse: Fitch also estimated that the potential average payment increase on the re-casting loans to be 63 percent, representing on average an additional $1,053 due each month."

For many homeowners that are already on the brink an extra $1,050/mth is simply too steep and unfortunately this means up to another 500,000 people are at risk to losing their homes in the next 2 years. These loans were particularly popular in Florida, Las Vegas and California, so the pain in those real estate markets will persist.

Market update - Stocks continue to get battered as I expected. Falling oil and a stronger dollar are doing nothing to stop the bloodletting. Hedge funds are in a tough spot b/c they have to make their number in Q3, but they run the risk of falling another 10% and getting shutdown. I'd look for a little bounce here (I'm starting to get long a little at a time -- just for a trade) but the long-term downtrend remains intact.

I'll use any real strength to build long-term short positions.

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